Grayscale, yes.
Before you can import it, you must have the import export folder (imptexpt) with two files inside: waterc.bmp and waterd.bmp.
The easiest way to create them is to export whatever you already have directly from the TE, then copy your new waterd.bmp file into the imptexpt folder replacing the exported waterd.
White is land, everything else is water depth. Be carefull not to have too many depth changes or your final terrain will be huge.
Don't forget to save a version of your final waterd file at 4096, so you can use it as a mask to paint the ground textures. This will avoid painting ground textures too far out into the water, then go back and touch up the beaches and shallows.
Have fun.
